Quick Guide: Functional Expense Classifications for Nonprofits

Be sure you know the difference and understand the context in which they are used. Return to the Internal Reports Introduction page for links to greater detail on how to read various reports as well as recommended formatting. This might include event expenses, donor outreach efforts, marketing campaigns, and salaries for development staff. If your organization files Internal Revenue Service (IRS) Form 990, maintaining this report is necessary to retain tax-exempt status if annual gross receipts exceed $200,000 or total assets are over $500,000. The costs of salaries of employees working on raising funds go into this account.

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Every nonprofit that raises money from contributions likely incurs fundraising expenses. It’s possible these expenses are quite low, especially if the organization is being run by volunteers. At the close of the reporting period, review functional expense classifications. Make note of material differences, making sure that the variances make sense and can be explained to end-users. The chart of accounts (COA) of the organization should efficiently facilitate functional expense allocation.

• Natural expenses are categorized by their natural classifications– for instance, employee salaries, rent, utilities, maintenance, and the cost of supplies are all examples of natural expenses.
• A nonprofit organization primarily runs on money raised by donors and funding groups.
• Generally speaking, there are two ways to organize expenses in your nonprofit’s operating budget.
• Let’s get started with an overview of the statement of functional expenses and how it fits into your nonprofit’s financial management practices.
• Jo-Anne Williams Barnes, is a Certified Public Accountant (CPA) and Chartered Global Management Accountant (CGMA) holding a Master’s of Science in Accounting (MSA) and a Master’s in Business Administration (MBA).
• Our nonprofit accountants have had success in providing complete and accurate statements of functional expenses for nonprofit businesses.

In 2004, the Urban Institute Center on Nonprofits and Philanthropy at Indiana University conducted a study of over 250,000 IRS Forms 990. 37% of nonprofits with at least $50,000 in contributions reported zero fundraising expenses. 25% of nonprofits reporting $1 to 5 million in contributions reported zero fundraising expenses. While this study is getting a bit old, we think it still speaks to a core problem, especially among smaller nonprofits that can’t afford professional help.

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For example, pie charts showing different revenue sources or bar graphs comparing year-over-year growth can quickly and effectively convey key messages to important stakeholders. This question comes from a common myth about nonprofit budgeting—that because your organization can’t turn a profit by definition, your total predicted revenue for the year always has to equal your total expenses. In reality, the meaning of “nonprofit” is simply that your organization has to reinvest all of its funding into its mission rather than paying investors or shareholders. Looking at the number of people working on each program at the nonprofit business and the expenses they accrue, one can determine each individual employee’s and program’s expenses. This allocation method is only effective for nonprofits with a small number of employees, often that does not exceed more than a thousand employees.

Categories of Functional Expenses for Nonprofits

If you are new to nonprofit accounting, your first step is to understand the basic principles and needs of statements of functional expenses. This includes understanding how to allocate functional expenses into classifications to build a functional expense report. When most people think about nonprofit organizations, they do not think about the accounting needs and financial reports needed to track the spending, earnings, and economic trends of the corporation. We tend to think about nonprofit businesses as non-financial businesses, which is a colossal error.

• Our tools guide you through every step—from collecting information to organizing data and structuring reports—so you can easily classify expenses by function and nature.
• This category works by counting the number of people working on a project and the expenses each person makes.
• The focus on administrative and fundraising expenses, however, can create a “nonprofit starvation cycle,” where organizations feel compelled to underreport essential administrative expenses.
• For example, an organization may incur travel expenses related to program services, fundraising and management activities.

For further guidance on tailoring your reporting to effectively communicate your organization’s story, consider reaching out to a trusted advisor. The impact of the Form 990 method is that expenses on the 990’s statement of functional expenses will reflect a greater percentage of program services than the corresponding percentage on GAAP basis financial statements. Nonprofit accountants should have a basic understanding of nonprofit fundraising software, and how to help their clients keep up-to-date records of expenses through the use of these software solutions. Capital Business Solution’s nonprofit fundraising software training assists in understanding how to prepare financial reports for nonprofit organizations.

Functional expenses are the classification of an expense to understand its function. The Statement Of Cash Flows reports on all cash flowing into and out of the nonprofit organization. Specifically, the statement demonstrates the extent to which the organization’s programs and activities generate and use money.

Your nonprofit’s budget should be organized to align with other key financial resources, including your what are functional expenses a guide to nonprofit accounting internal records, financial statements, and tax returns. A nonprofit organization can have each employee record how they spend their time– looking specifically at how much time is spent between fundraising, general management, and programs. Since the nonprofit’s primary focus is educational programs, most expenses are allocated to program services, ensuring resources directly benefit the mission.

The most important thing is establishing a clear process and methodology for allocating your expenses. And the balance (17,000 sqft) is used as classroom space to execute your programs. These 3 expense categories are mandatory for the IRS, but you may choose to track others internally. Our mission at Long Island Business News is to be the vital business news and advertising source to Long Island’s most influential readers. Additionally, when forecasting the coming year’s revenue, it’s best to be cautious in your estimates so you’ll be more likely to have the funding you need to achieve your goals, no matter what external circumstances occur.

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Please do not copy, reproduce, modify, distribute or disburse without express consent from Sage.These articles and related content is provided as a general guidance for informational purposes only. These articles and related content is not a substitute for the guidance of a lawyer (and especially for questions related to GDPR), tax, or compliance professional. When in doubt, please consult your lawyer tax, or compliance professional for counsel.

If you’re ready to dive into creating budgets for your nonprofit, there are various templates available online to help you get started. Every organization’s budget will look slightly different, so make sure you can customize your chosen template to fit your needs and goals. The SOFE, therefore, not only fulfills regulatory requirements but also serves as a communication tool, helping nonprofits foster trust and understanding with their donors and the broader public. Adhering to FASB standards and IRS requirements is essential for nonprofits to maintain credibility and legal compliance.

As per Financial Accounting Standards Board’s requirement, a nonprofit organization is supposed to categorize the expenses on the basis of its purpose. Natural expenditure here tells us about where the money went in respect to what in return. Get our FREE guide to nonprofit financial reports, featuring illustrations, annotations, and insights to help you better understand your organization’s finances.

For some not-for-profit entities (NFPs), a separate statement of functional expenses will be the most efficient and effective way of presenting the analysis of expenses by function and nature that is required under FASB ASC 958. With that in mind, the following are some best practices for organizations to keep in mind as they prepare these schedules. One of the best practices and critical elements of a functional allocation methodology is documenting your allocation plan in writing. This written plan helps your governance board, auditors and any other users of the financial statements understand your allocations. It is important that you know the type of expenses that are directly (or indirectly) allocated, as cost allocation can be important in terms of grant reporting and determining the success of a program.